Can we use volatility to diagnose financial bubbles? lessons from 40 historical bubbles

Abstract

We inspect the price volatility before, during, and after financial asset bubbles in orderto uncover possible commonalities and check empirically whether volatility might be used as anindicator or an early warning signal of an unsustainable price increase and the associated crash. Someresearchers and finance practitioners believe that historical and/or implied volatility increase beforea crash, but we do not see this as a consistent behavior. We examine forty well-known bubbles and,using creative graphical representations to capture robustly the transient dynamics of the volatility, findthat the dynamics of the volatility would not have been a useful predictor of the subsequent crashes.In approximately two-third of the studied bubbles, the crash follows a period of lower volatility,reminiscent of the idiom of a “lull before the storm”. This paradoxical behavior, from the lensesof traditional asset pricing models, further questions the general relationship between risk and return.

Keywords

• bubble| boom| bust| crash| prediction| volatility| risk-return